Exiting a Covered Call Position Prior to Earnings by Guest Author Laurie Itkin

JUST BECAUSE YOU BUY ITS PRODUCTS DOESN’T MEAN YOU SHOULD BUY ITS STOCK

The KORS initial public offering was the topic du jour among my girlfriends at a holiday party last December. The ladies I know who invest in stocks were trying to figure out how to get in on the IPO before the share price surged. It is human nature to want to invest in companies you like, especially when you are a consumer of their products! My favorite purse is a Michael Kors. Every time I carry it, its caramel-colored, buttery leather causes my friends and acquaintances to pepper me with compliments.

So why not invest in this fab company? Especially when my friends were planning to do so? First of all, just because I like to “buy and wear” a company’s clothes and accessories doesn’t mean I want to “buy and hold” its stock. I used to invest in only stocks but when I evolved into a covered call writer, my emotions took a back seat to logic. Successful covered call writers are logical and follow rules. Although writing out-of-the money calls can be an income supplement to buy-and-hold investing, typically the covered call investor isn’t wed to a specific company for any serious length of time. We are generally looking for maximum return, with minimum risk, within a defined time period.

Some of my friends bought stock the day of and day after the IPO but I held out. The Blue Collar Investor advises caution when attempting to trade a stock with little or no trading history.

In the face of a tepid stock market, KORS had a successful IPO. Its shares opened at $25, up 20% from its $20 offering price, and closed the first trading day at $24.20. (Contrast that with the Facebook IPO.) If you had gotten in at that time, you would have earned a great return. But had you bought the stock later, perhaps in late February or March, your investment would have stayed flat through mid-August. Unless you were writing covered calls, your money wouldn’t have been working for you.

Earnings season is here and as the chart illustrates, in two of the three quarterly earnings events, the stock gapped up significantly. Will that happen again on November 13? I don’t know, but what I do know is that I was delighted to see KORS show up as a fairly strong covered call candidate on the BCI premium report!

It was like waiting nine months for a beautiful purse I had been coveting to go on sale. On Oct 15 I submitted an order to buy 200 shares at $53.87 and sell 2 Nov 17 calls with a $55 strike price at a premium of $2.92 a share. Typically OTM calls wouldn’t have such a high premium but since earnings are announced within the November options cycle, that partially explains the high price. KORS had been on the BCI Premium Service “running list” for ten weeks and had a fairly high and constant segment rank of B/B.

KORS accelerates after IPO

BCI advises against holding positions during an earnings announcement because the implied volatility of the stock can manifest in either an upward or downward move. I don’t go to Vegas to gamble and I don’t play the lottery. BCI also advises against entering a position during the month of an earnings announcement. This is a rule I generally follow. I wouldn’t normally enter into a new position when there is an earnings announcement within that options expiration period; however, in this case I made a limited exception because the earnings announcement was only a few days before expiration. I entered into the position with a clear intent to exit before the Nov 13 earnings announcement. I have a note on my calendar to close the position (sell the stock and buy back the call) on Nov 12 which is a few days before the Nov 17 expiration. I may close it earlier than that if the stock stays above $55 and I have reached at least 80% of my maximum gain. I will not be rolling the call into December before the earnings announcement, in line with the BCI rule. After the announcement, I will then reevaluate the situation and consider selling a December covered call (at the same or different strike price) only if the price and chart activity remain favorable. I will also be checking the BCI premium report to ensure that KORS is still on the running list.

Here is what the profit and loss chart tells me:

P&L chart for KORS

My max gain is $810 which I will realize if the stock stays above $55 by expiration. The high premium gave me lots of downside protection and I break even if the stock goes down to as low as around $51. Since I want to be out of the position before the Nov 13 earnings announcement, I need to determine what my potential gain could be if I closed the position before then. The red line shows max gain if I stay in through expiration. The white line is what the gain would be on Nov 12 under various potential prices of the underlying stock.

I’m typically satisfied if I make 70-80% of maximum gain for any position so I think my plan to sell the stock and buy back the call before the earnings announcement will provide me a nice reward with little risk.

I am humbled to announce that I have been nominated as a finalist in the Author’s Show contest “50 Great Writers You Should Be Reading” If successful, I will be included in an upcoming publication of the same name.Many thanks to YOU, our members, for “putting me on the map” and to the Author’s Show for this honor.The voting runs from November 2nd to November 11th. My three books are currently ranked 1, 2 and 3 on Amazon.com on the subject of covered call writing. As many of you know, I have been writing weekly blog articles on this site for the past five years and guest blog for Seeking Alpha and OilPrice.com. If I have earned your vote, here are links to the contest information and to the vote page:

The good news is that economic reports are looking positive for our recovery. However, global, political and climate-related issues are making investors nervous and market tone tenuous:

Friday’s jobs report showed an increase of 171,000 jobs while 124,000 were expected

Unemployment rate upticked to 7.9% (as expected) as more people are looking for work

Personal income was up 0.4% (0.3% expected)

Personal spending rose by 0.8% (0.6% expected)

Initial jobless claims for the week ending 10-27-12 was at 363,000 (370,000 expected)

Consumer Confidence for October rose to 72.2 according to the Conference Board

According to the Department of Commerce September factory orders rose by 4.8% (3.0% anticipated)

For the week, the S&P 500 rose by 0.2% for a year-to-date return of 15%, including dividends.

Summary:

IBD: Market in correction

BCI: This site is taking a cautious approach at this time, favoring in-the-money strikes, low-beta stocks and ETFs. Less experienced investors should consider keeping at least some cash on the sidelines until a more definite market tone can be established. We are still long-term bullish.

About laurie

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The short answer is yes. There will be fewer candidates that pass this screen with 6 green ratings on the check list. However, this screen WILL identify those equities and industries that are performing well despite the overall bearish environment in your hypothetical. Fortunately, 2008 was an EXTREME ABBERATION as we normally WILL find a watch list of 40-60 eligible cc writing candidates using our BCI methodology.

Using those eligible stocks and ETFs that do pass our screens, along with appropriate strike selection, proper exit strategy execution and low-beta candidates will assist us in navigating most market conditions. As a disclaimer, I must re-publish the fact that I went into cash in the latter part of 2008 and re-entered early in 2009.

This great-performer is a stock for investors with a higher risk tolerance. On October 25th, SWI reported a stellar 3rd quarter earnings report with a positive surprise of 14.3% and revenues up 33% year-to-year. Guidance was elevated to reflect a projected 2012 revenue growth of 33% and a 5-year EPS growth rate of 20%. Its ROE (return on equity) stands at 27.2% compared to its industry peers’ 13.5%. Our premium running list shows a mediocre industry segment rank of “C” and a high beta of 1.47.

Asbury Atomotive announced a stellar 3rd quarter earnings report on October 23rd with earnings up 71.4% year-to-year as revenues rose by 14%. ABG boasts positive earnings surprises in 10 of the last 12 quarters with an average beat of 19%. Estimates have risen as well with growth projections of 44.1% and 11% for 2012 and 2013.

This stock is fairly valued as well with a forward PE of 11.8 (under 15 is good value), a price-to-book ratio of 2.5 (under 3 is good value), and a PEG ratio of 0.54 (under 1 is good value). It’s return on equity (ROE) is 22.3% well above its peer group average of 16.8%.

Our premium “running list” shows an industry segment rank of “A”: and a beta of 1.47.

A modified version of the BCI ETF Report has been uploaded to your premium site. Look in the “resources/downloads” section of the site for the report dated 11-8-12.

The reason for the modified version is that our office is still without power as a result of the recent hurricane and follow-up snow storm. Once power is restored, we will return to the format that includes charts and graphs. Our stock report will continue in the standard format.

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